Intel: Wait For Pullback To The Low $20s

Intel (INTC) is the world's largest chip maker with revenues in excess of $54 billion, and a gross profit margin of 63.6%. On January 19th, Intel reported it had completed an "exceptional year" by ending 2011 with revenues up 24% from the previous year and Earnings per Share up 19%. By all accounts, Intel had a record year. Intel's stock has also seen a steady upward trend from around $25 when 2011 year-end financials were announced to near $28.50 recently. Q1 2012 earnings announcements are right around the corner, and the question to be answered is whether Intel is still a good buy or if the recent run-up has made the margin of safety too small to justify buying.

Any well reasoned analysis needs to take a look at competitors. Intel's competitive universe includes one arch-rival in Advance Micro Devices (AMD), and one upstart in ARM Holdings plc (ARMH). AMD is a fraction of Intel's size and one of its few direct competitors. On January 24th, AMD reported 2011 annual results of $6.6 billion in revenue, which was essentially flat from the previous year as well as a sharp drop in operating income with $368 million for 2011 down from $848 million for 2010. Gross profit margins for 2011 were 45%, down slightly from 2010's 46% level. AMD announces Q1 2012 results on April 19th, and per the CFO commentary released on January 24th, the company is expecting Q1 revenue to drop around 8% from the previous quarter and gross margins are expected to stay constant at 45%.

Despite this lack-luster performance, recent financial news for the company has not been all bad with AMD hitting all time records for client and mobile microprocessor sales. Cash flow (non-GAAP) also improved by 48% to $528 million in 2011. AMD's ability to continue to compete with Intel and other potential chip makers will require maintaining high levels of research and development spending, which it intends to keep constant on a percentage basis from 2011. Lastly, AMD is attempting to improve operational efficiencies and to reinvest the resulting savings into initiatives focused on low power processors, emerging markets and cloud computing. Potentially, the most serious issue for Intel in the near term concerning AMD is the company's relationship with GlobalFoundries.

On March 4th, AMD announced that it was transferring its remaining equity stake in GlobalFoundaries back to the company in exchange for allowing AMD to use other manufacturers to build chips. GlobalFoundaries was spun off from AMD in 2009 and during that time GlobalFoundaries had exclusive rights to manufacturer certain processors. This transfer of equity may potentially allow AMD to reduce costs enough to allow for a pricing war, which would be detrimental to both companies' margins.

ARM Holdings, potentially Intel's primary competitor of the future, provides micro processing intellectual property though licensing agreements with its customers. These licenses along with other technologies are used primarily in handheld devices such as smartphones, tablet computers and other electronic devices. On March 13th, ARM announced the release of the world's most energy efficient microprocessor, named Cortex -MO+. This new ultra-low power processer may allow the use of microprocessors in products where they are not currently used, such as certain medical devices and white goods.

Every indication shows that Advance Micro and ARM Holdings will continue to enhance their low power chips by adding more processing capability to gain market share in the smartphone and handheld tablet market. Intel announced earlier this year that it will supply its Atom chip to Motorola Mobility (MMI) in a multi-year partnership and to Lenovo in a strategic relationship. The Atom chip is Intel's low-powered chip specifically designed for smartphones and tablets. The Atom chip will allow Motorola to drive down the cost of processors in smart devices and enter high growth markets such as India and China.

Intel is truly one of the pioneers and giants of the technology world. Placing a value on its equity is tricky as so much of its future revenue depends on products that have not yet been created. The three best know approaches for valuing equity are discounted cash flow, relative value and recent transactions. For Intel, we can assume the recent transaction approach will be of limited applicability due to Intel's size ($54 billion of revenue in 2011) and its market share (likely in excess of 80% for microprocessors).

A second approach, a type of discounted cash flow, is a simple dividend discount model. I believe dividends are important contributors to investors' overall return and dividend discount model provide good baseline valuation. Unfortunately, technology firms generally poorly fit the dividend discount model due to the industry's erratic earnings and low to zero dividend yields. Intel is a little different with a dividend yield close to 3%, and I believe that this baseline approach has some applicability for Intel. In addition to a simple dividend discount approach, the most theoretically sound method is a full discounted cash model. This approach is useful for not only Intel, but nearly any company with a long operating history. To validate whether my discounted approach is holding, I will compare Intel to the market using common ratios.

Intel's current dividend is 84 cents a year. This is equal to a payout ratio of using operating cash flow of roughly 20% on dividends alone. To get a better sense of how much Intel is returning each year to its shareholder requires determining the net effect of share buybacks less share issuance for compensation (stock options). The accounting for this can be very detailed, but using just the cash flow statement, I was able to identify that Intel was returned 78% of 2011 operating cash flow to its shareholders. This causes me a bit of concern as Intel's future success requires a hefty investment in the form of research and development ("R&D"). In my opinion, this level of shareholder return is not supportable and a growth rate in cash available to the common equity is likely closer to 8%. Combine this with an estimated cost of equity of 12.90% and a baseline value of Intel is approximately $28 a share.

Many of the assumptions needed to develop a dividend discount approach are needed as inputs in a well built full discounted cash flow model. The primary concerns I have for Intel in reaching a discounted cash flow value of its stock are around revenue growth. Intel's nominal revenue growth will be highly tied to its ability to generate non-U.S. sales in order to maintain high single-digit growth. This seems possible should emerging markets continue to maintain GDP growth above 6% in market such as China and India. If earnings before taxes and interest maintain a level consistent with the last ten years, roughly 25%, then I believe Intel's intrinsic value is roughly $27 share on a discounted cash flow basis using sales growth as the primary driver.

Historically, Intel has traded at a slight premium to the S&P 500 on a price to earnings basis. Since 2010, the company has traded at a discount. This discount would be reasonable if Intel's growth prospects were likely to trail the S&P 500 over the long-term, but that is unlikely. Assuming that a 14 price to earnings multiple is reasonable for the S&P 500 and is also be reasonable for Intel, then Intel is worth approximately $34 a share on 2011 earnings.

My three approaches to estimating Intel's stock value ranges from $27 to $34 a share. I believe the price to earnings discount is likely to continue in 2012 as revenue growth estimates continue to be weaker than 2011 for Intel, hence $34 is at the high end. I would be comfortable purchasing Intel at a 20% margin of safety to the $27 price estimate, which translates to a target purchase price of $21.60. Intel has had an excellent run due to its continuing dominance of the microprocessor market and improving operating performance.

Its long-time rival AMD does not likely present a serious threat to Intel, but could erode margins if AMD elects to start a price war. The longer term challenge is converting Intel's dominance of the PC market to smartphones and tablets where upstart competitor ARM Holdings has been racking up success after success. Investors should pay close attention to Intel and, should the 1st quarter rally of 2012 fizzle in the 2nd quarter, then an opportunity may become available to purchase Intel at a significant discount to fair value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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